Small cap prophets: A profit season guide

Tomorrow marks the official start of the full-year reporting season and there’s a high wall of worry for small cap investors to scale given the unhealthy mix of economic and political uncertainties that lie on our immediate horizon.

What’s worse is that views on this reporting season vary widely, with a number of experts warning that earnings are likely to miss their mark as companies struggle to hold their own against high costs, volatile commodity prices, big swings in the exchange rate and poor business and consumer confidence.

Feeling nervous yet? I won’t blame you, as the uncertain outlook for the market is likely to persist for most of the first-half of the current financial year.

While it might not bring total comfort, I posed three key questions to a roundtable of leading small cap fund managers in the hope that it will help investors navigate what could turn out to be a treacherous reporting season.

The fund managers are Sandy Grant from WilsonHTM Priority Growth Fund, Jeremy Bendeich from Avoca Investment Management, Ed Prendergast from Pengana Capital, ST Wong from Prime Value Asset Management, and Carlos Gil from Microequities.

Q1: What are you expecting in the August reporting season?

Grant: We expect a fairly subdued reporting season for small companies, but given the relatively high valuation multiples attached to many companies, there is scope for some share price declines despite many companies already giving earnings guidance.

In a similar manner to the share price performance of the past two years, the gap between the good companies with a clearly defined strategy that is being well executed and other companies that have no sustainable competitive advantage is likely to be vast.

Generally speaking, we continue to favour the industrial small companies relative to the small miners with little strategic or cost advantage.

Bendeich: We expect that earnings for cyclical companies will have deteriorated in the last quarter of FY13, as the economy noticeably softened. Small cap stocks that are highly leveraged to this are discretionary retail, and industrial services. Given continuous disclosure requirements, the key risks will be around the FY14 outlook statements.

The RBA will cut interest rates and in 12 months the rate of decline in economic growth should bottom out and Australia will grow, albeit at a slower pace. As a result, we will be watching for quality names that get oversold this reporting season.

In aggregate, FY14 consensus earnings growth looks high given governments have to reduce spending and increase taxes, and consumers will not respond until employment stabilises.

Prendergast: Market forecasts for small caps are potentially too high in sectors such as retail and media where consumer and business confidence has not recovered, hence draining the rate of recovery already baked into forecasts.

Also, companies exposed to business spending are likely to provide poor outlook statements given anecdotal feedback regarding corporate spending.

Wong: The probability of disappointment should be reasonably low, on the back of investors selling down the obvious sectors and ongoing profit downgrade disclosures.

In addition, investor expectations should be somewhat more subdued as the macro backdrop has softened. There may still be room for disappointment from write-downs impacting, say in the junior miners segment.

In addition, the continuing downgrades amongst mining services companies could still throw up negative surprises.

Gil: The recent share price rises in many small cap companies needs to be validated by a rise in earnings, otherwise this could plausibly lead to downward pressure on market prices.

I think industrial businesses not exposed directly or indirectly to resources are also going to have a challenge to deliver strong growth. However, one of the benefits of some selected small companies is they do have the ability to grow irrespective of the prevailing macroeconomic environment.

Q2: What are some of the key things you will be watching out for in the results?

Grant: We are forecasting modest sales growth figures for the last half across most companies given an uncertain political environment and low consumer confidence restricting sales growth. Clearly mining companies, especially the mining service companies, are likely to report sustainably lower revenues for the last six months of the year.

One of the more interesting features of this reporting season will be the attitude of auditors and company directors to asset values. Following the decline in returns from many businesses there will potentially be pressure on some companies to make adjustments to some of the carrying values of some of the assets on their balance sheets. Although these balance sheet adjustments are non-cash items, there will nonetheless be pressure on some of these companies to potentially raise equity to repair their financial position.

Bendeich: Revenue growth will be hard to come by given weak economic conditions. Margins will likely come under pressure in this environment, especially for importers who have had a free kick from a high Australian dollar.

The mining services sector will continue to experience increased margin compression as excess demand flips into excess supply. This will impact revenue growth and margins. In addition, working capital requirements will increase as customers demand better terms.

Prendergast: Mining services is likely to be the source of further disappointment. Notwithstanding the slew of downgrades over the past six to nine months, we still expect further downward adjustment to expectations based on lower revenues and tighter margins.

As witnessed by the sharp correction in Ausenco’s price following its downgrade this week, the market is clearly still adjusting to the worsening environment. Hence arguing that it is already “in the price” is bold.

Wong: I have segmented my analysis to two key segments – stocks that have outperformed year-to-date, asking the question of whether they will continue to do well; and the underperformers – is there value to be found?

Best performers year-to-date include three key sectors: consumer discretionary (including online companies), diversified financial services and junior telco companies. I will be focussing on the companies’ ability to sustain and improve profitability through demand growth and their ability to price against the backdrop of slower economic growth, the employment picture deteriorating and interest rates cuts that have yet to bite in a meaningful way.

On the downside, the worst performers year-to-date squarely include junior mining companies and mining services companies. Mining services clearly continues to be under pressure, and therefore I am looking for managements’ responses to managing the difficult outlook and the state of cash flows and balance sheets.

Gil: In each company we observe a softer set of KPIs (key performance indicators) for management. Generally, earnings quality is always important, so we’ll be keeping a close eye on metrics like operational margins including gross and EBITDA (earnings before interest, tax, depreciation and amortisation) margins.

Q3: Which small cap stock(s) do you think will surprise on the upside or downside?

Grant: Companies with strong structural growth stories and competitive advantages are likely to post strong revenue gains. Included in this group would be Titan Energy Services (TTN), Silver Chef (SIV), Slater and Gordon (SGH), Drillsearch Energy (DLS) and NEXTDC (NXT).

Although there have been a number of the mining service companies have indicated that revenue growth has declined sharply in the second half, there may still be some disappointing revenue figures in this area of the market.

Bendeich: Two stocks that may positively surprise are Austbrokers Holdings (AUB) and Silver Chef (SIV). Austbrokers’ recent acquisitions and premium rises may contribute more than expected to FY13/14 numbers.

Silver Chef’s growing customer base, cafes and restaurants make it the fastest growing segment of retail, and their Go Getta product is gaining traction which could lead to another positive FY14 year.

On the other hand, Domino’s Pizza Enterprises (DMP), trading on a high price-earnings (P/E) multiple, is vulnerable to further weakening in economic activity in both France and even in Australia – as McDonald’s recent trading update suggested.

SAI Global (SAI) may experience continued organic revenue growth pressure, and with no recent acquisitions, FY14 growth of 10% in earnings before interest, tax, depreciation and amortisation (EBITDA) could be stretched.

Prendergast: My tips for positive surprises are M2 Telecommunications Group (MTU) and Amcom Telecommunications (AMM).

M2 is positioned to show solid earnings growth driven by the benefits of the Primus and Dodo acquisitions, plus a resumption of organic growth in its core SME operations. The defensive nature of its revenue streams insulates it somewhat from economic volatility.

Amcom is expected to continue its 20% earnings growth rate driven by further expansion in its fibre network in the Western Australia market. The move into cloud-based services provides a faster growing adjunct to its traditional offering.

Wong: In terms of small cap companies that could surprise, the diversified financials might be a possible area that could surprise positively. Companies such as BT Investment Management (BTT) and Henderson Group (HGG) could post better margins and increase dividend payouts.

Consumer discretionary companies that have been bid up on account of interest rates making an impact on consumer spending may warrant some caution. The top-line growth outlook may be anaemic, whilst margins could be weaker than expected. Examples include OrotonGroup (ORL), APN News and Media (APN) and Pacific Brands (PBG).

Gil: We expect Vocus Communications (VOC) to deliver strong organic growth. If you look across the telco sector, including large companies like Telstra (TLS), M2 Telecommunications (MTU) and iiNet (IIN), the sector lacks true underlying organic growth and most of the growth from the larger players is acquisitive-based growth.

Vocus is an exception. We expect the business to continue to deliver fast organic growth, particularly in its fibre optic services business.

In terms of downside risks potential, we are not seeing any evidence of any marked improvement in Australian retailing conditions. So, for retailers, we would be wary of any short-term expectations to the contrary. Therefore, our expectations for companies like Noni B (NBL), Specialty Fashion Group (SFH) and Gazal Corporation (GZL) are tamed.